Strategic and Financial Decision-Making - Essay Example

Strategic and Financial Decision-making Table of Contents Table of Contents 2 Part1- 3 Part 2- 5 Part3- 7 Part 4- 9 Part1- a- Beta measures the sensitivity of the security returns to market movements. It measures the volatility of a security. Stocks exhibiting large changes in price as compared to an index like FTSE 100, on up as well as down side are considered to be more volatile and are assigned high beta values (Gildersleeve, 1999, pp.70). For the assignment Sage Group (SGE) and Diageo Plc (DGE) have been selected. Sage Group is a software and computer services company in UK. Diageo Plc is a leading company in premium drinks with a collection of brands across wine, spirit and beer. Both the companies are listed under FTSE 100. The beta of stock can be calculated as- β = Covariance of stock (j) with the market (k) / Variance of market = Covariance (j, k) / σ2 As per this method, the beta of Sage Group is 0.749 and of Diageo Plc is 0.60 (Yahoo Finance-a, 2010; Yahoo Finance-b, 2010). b- Under CAPM the calculation of cost of capital depends on the principle that the rate of return required on a security is equal to the risk-free rate of interest plus a risk premium, based on the following formula- E(Rj) = Rf + β [ E(Rm) –Rf)] E(Rj) is the required or expected rate of return on the security β is the asset’s co-efficient Rf is the risk free rate of return E (Rm) is the return expected from the market Based on this approach the beta of Sage group is calculated as 0.78. The beta of Diageo Plc as per this approach is 0.63. Part 2- The beta of Sage Group has been reported as 0.818 in the Bloomberg site (Bloomberg-a, 2010). Diageo Plc’s beta has been published as 0.753 in Bloomberg site (Bloomberg-b, 2010). Therefore the beta of Sage Group as per calculations is less than the beta that has been published in Bloomberg site and the beta of Diageo Plc as per calculations is also less than that has been published in this site. There can be many reasons for this difference. Like in the case of data like beta that is reported by a site the calculations are more extensive. For the purpose of the calculations, the monthly returns relating to the last twenty four months only has been taken. But the beta estimation in Bloomberg is based on either daily returns or quarterly returns over a long span of time. Some sites base their calculations on the data since the stock inception. As the beta calculated by these sites is based on a longer span of time therefore they are more reliable as it covers a larger number of data points. So the difference in ‘time frame’ can result in different beta estimates. Some of the financial services use weekly observations while others use monthly observations whereas others base their calculations on the last day of trading. Another reason for the varying beta is that they are calculated using different indices in the market. Some sources use Standard & Poor 500 as the benchmark index, some use Russell 1000, 2000 and others use Value Line Index. In such situations the best way is to choose which provides the beta for most of the companies in the guideline (Pratt & Niculita, 2007, pp.211) It may be possible that the fundamentals of the company have changed over time in that case the beta that is calculated based on a recent period is more reliable (Pratt & Grabowski, 2008, pp.141). Based on this it can be said that the beta based on the recent period is more reliable as compared to an outdated beta. Part3- Beta measures the sensitivity of stock returns to the market returns. For some stocks the volatility in the stock returns is higher than the market index whereas for others the volatility in returns of the stock is less than the market. The stocks of the former category are referred as ‘aggressive’ stocks by the investors and the stocks belonging to the latter category are called ‘defensive’ stocks. Aggressive stocks have a beta of more than one and the defensive stocks have a beta of less than one. As the beta of Sage Group and Diageo Plc is less than one, it signifies that both the stocks are defensive investments. This means that the fluctuation in their prices is less as compared to the market. A beta of 0.749 for Sage Plc indicates that if the market moves up or down by 100 percent the rise or fall in the stock price of Sage Group Plc will be nearly 74 percent respectively. This signifies that both the rise as well as fall in its price will be less than the market index. Investing in the defensive stocks is ideal when the market conditions are not certain. If there is a fall in the market the fall in the value of the stock will be limited. Similarly if the market conditions are good then an investor can take the advantage of market upswings by investing in high beta stocks. Low beta stocks are preferred by investors who do not want to risk their funds or are not sure about the market direction. For such stocks the gains are less than the index during an upswing and the losses are less than the index during a downswing. The beta of Hewlett Packard (HPQ) is 0.98 which is very close to one (Yahoo Finance-d, 2010). The beta of Royal Bank of Scotland is 1.706. This signifies that it is an aggressive investment (Bloomberg-c, 2010). The equity of this company will yield good returns when the conditions in the markets are positive. The stocks with a beta of less than one are referred as defensive stocks. These stocks are immune to any changes in the macroeconomic conditions and generally have low beta. Irrespective of the market sentiments, these companies sell their goods and services. Important examples of defensive industries include “retail food chains”. This is because the people purchase at groceries stores both in good as well as bad times. Similarly, tobacco and alcohol businesses sell products irrespective of the rate of interest, unemployment, inflation etc. or other macroeconomic factor. For this reason the beta of Diageo Plc is less than 1 at 0.60 signifying immunity from market movements. The last group belonging to the defensive category is “utilities”. The usage of basic amenities like light, telephone etc does not depend on whether the people are working or not (Strong, 2008, pp.290).Tesco is a food & Drug retailer with a beta of 0.77. It serves as a good example of a “utilities” company with a low beta (Bloomberg-d, 2010). So it can be said that the companies that are influenced by macroeconomic factors like rate of interest, monetary policies etc like the financial services firm tend to have a high beta. Any adverse announcement in the rate of interest can trigger a fall in the value of these securities due to a fall in the market index. Investing in such stocks is profitable only when one is sure about the direction of the market. In the event of any adverse market movements the losses on these stocks will be much higher and can erode the value of the portfolio significantly. Part 4- a- The limited availability of resources makes it mandatory for the business to assess the worthiness of the project. This is done by discounting the anticipated cash flows by a discounting rate. It is essentially the return required by the investors of the company from the project. This kind of assessment becomes particularly necessary if the company is widening its business horizon by investing in an unrelated industry. However if the risk relating to future projects is the same as current projects, which may not always be true, then it is important that the company incorporates this aspect in the determination of the discount rate. For risky projects the investors require a higher compensation thus raising the return required from the project. If the acceptance or rejection of a project is based on Weighted Average Cost of Capital (WACC) then there is a probability of mistakenly accepting risky projects and mistakenly rejecting less risky projects. The use of CAPM method of estimating the cost of capital is the best method of project selection. This is stated as- Re = Rf + (Rm-Rf)β (Wilson-a, n.d.). CAPM model focuses on the systematic risk, helps in computation of WACC and has the scope of assigning different risk weights for different projects. The beta of a project is mainly affected by the relationship that exists between the revenue associated with the project and economic activity. It is also dependent on the amount of fixed costs. Suppose, a pharmaceutical company is planning to invest in a financial services company then the risk of the investment will move up. In the case of internal growth the risk exposure of the company will remain the same. The risk associated with the pharmaceutical stocks is less as is evident from its low beta but there is a high level of risk associated with investment in the financial services industry. The high beta of the financial service business will raise the equity beta of the investment which in turn will raise the overall discount rate of the project. So the foray into a different and unrelated business activity raises the cost of capital of the business, based on the risk associated with the new investment. If the cash flows from a business are uncertain then the business is considered to be a risky proposition. To compensate for the high risk the investors demand for higher returns. Thus higher the risk associated with the investment higher is the “risk premium”. b- The growth of a company can be of two forms. It can either opt for increasing the scale of operations i.e. raise the level of output or it can go for acquisition. Both the modes of expanding business operations have their own set of advantages as well as disadvantages. Internal growth is best for a business that is yet to achieve the optimal scale. For businesses operating below the optimal level the cost of production tends to be high making their goods incompetent in the market. By raising the level of output the company can manage to achieve the desired scale that will enable it lower the cost of output and acquire higher efficiencies. However, there are businesses that are operating at their optimal level. For companies that are operating at this stage the growth opportunities are very limited. The best method of expansion for these companies is to acquire companies that are in the nascent stage. They can use their cash reserves to make investment in companies that are growing and are expected to deliver good returns in the future. As the company is already experienced it can make best use of the resources of the nascent company. With time this company can be nurtured and can serve as an additional contributor of the wealth. Besides this a company can acquire another company for the purpose of increasing its market size. This is true in the case of recent acquisition of Cadbury Plc by Kraft Foods Inc. In the year 2008 the latter had a market share of 4.7 percent whereas in this year Cadbury Plc had a market share of 10.2 percent which is nearly double the share of Kraft Inc (York, 2009). The good-will of the reputed company can facilitate additional sales for the acquirer. So the acquisition of such a company brings with it the loyal customers of the acquiree. This can boost the profit margin of the company. Moreover it is possible that the acquiree enjoys certain privileges that the acquirer can access after acquisition. With the expansion in market size the company can command a greater power in the market. The increased size also brings in certain economies of scale such as lower output cost, reduction in research & development expenses etc. In the case of acquisition similar businesses the research units of the two companies can be integrated. This will lower the costs of research and raise the profit margins. Another reason for acquisition can be that if the managers of the company are not performing well, then in that case they can be replaced with efficient management personnel, which will improve the operations of the company and turnaround the company into a profit- making unit (Wilson-b, n.d.). Diversification is also one of the reasons for the takeover. Like a tobacco company can foray into consumer goods business. A tobacco industry is highly influenced by the policies and announcements like customs and duties. A rise in such duty can exert a pressure on the earnings of the company, however, the impact of such duties are less on consumer goods. So an investment of this type can help the company diversify its product base. Any adverse event in one sector will not impact the other sector thus acting as a cushion to the company. Reference Bloomberg-a. 2010. Fundamentals. SGE:LN Sage Group PLC. Available at: http://www.bloomberg.com/apps/quote?ticker=SGE%3ALN [Accessed on May 13, 2010]. Bloomberg-b. 2010. Fundamentals. DGE:LN Diageo PLC. Available at: http://www.bloomberg.com/apps/quote?ticker=DGE%3ALN [Accessed on May 13, 2010]. Bloomberg-c. 2010. Fundamentals. RBS:LN Royal Bank of Scotland Group PLC. Available at: http://www.bloomberg.com/apps/quote?ticker=RBS%3ALN [Accessed on May 13, 2010]. Bloomberg-d. 2010. Fundamentals. TSCO:LN Tesco PLC. Available at: http://www.bloomberg.com/apps/quote?ticker=TSCO%3ALN [Accessed on May 13, 2010]. Gildersleeve, R. 1999. Winning business: how to use financial analysis and benchmarks to outscore your competition. Gulf Professional Publishing. Pratt, P.S. Niculita, V.A. 2007. Valuing a business: the analysis and appraisal of closely held companies. McGraw-Hill Professional. Pratt, P.S. Grabowski, J.R. 2008. Cost of capital: applications and examples. John Wiley and Sons. Strong, A.R. 2008. Portfolio Construction, Management, and Protection. Cengage Learning. Wilson, P.-a. No Date. Capital Asset Pricing Model. Wilson, P-b. No Date. Strategies for Growth. Yahoo Finance-a. 2010. Historical Prices. DIAGEO ORD 28 101/108P (DGE.L). Available at: http://finance.yahoo.com/q/hp?s=DGE.L&a=04&b=1&c=2008&d=03&e=30&f=2010&g=m [Accessed on May 13, 2010]. Yahoo Finance-b. 2010. Historical Prices. SAGE GRP. ORD 1P (SGE.L). Available at: http://finance.yahoo.com/q/hp?s=SGE.L&a=04&b=1&c=2008&d=03&e=30&f=2010&g=m [Accessed on May 13, 2010]. Yahoo Finance-d. 2010. Stock Price History. Hewlett-Packard Company (HPQ). Available at: http://finance.yahoo.com/q/ks?s=HPQ+Key+Statistics [Accessed on May 13, 2010]. York, B.E. 2009. What Landing Cadbury Would Mean for Kraft, Ferrero, Hershey. Available at: http://adage.com/article?article_id=140648 [Accessed on May 13, 2010]. Bibliography Yahoo Finance-c. 2010. Historical Prices. FTSE 100. Available at: http://finance.yahoo.com/q/hp?s=^FTSE&a=04&b=1&c=2008&d=03&e=30&f=2010&g=m Bloomberg-e. 2010. U.K. GOVERNMENT BONDS. Government Bonds. Available at: http://www.bloomberg.com/markets/rates/uk.html Annexure- Read More